ETF Guide: ET-what? A primer on exchange-traded products

Although ETFs are the major asset class under the ETP umbrella, traders also have other options within the category, namely, exchange-traded notes (ETNs). ETNs are similar to ETFs in that both track the performance of a given index. But, while ETFs hold the underlying assets of that index, ETNs represent debt issued by a bank, which promises to pay the return on the index.

This guaranteed return is an advantage that ETNs hold over ETFs, which are subject to tracking error. “You don’t have to worry that the ETF portfolio manager might not buy all the right stocks…therefore it doesn’t track the index perfectly,” Iachini says. “With an ETN, there’s a promise: They say, ‘We will pay you this return.’”

But, unlike ETFs, ETNs are dependent on the good credit of the issuer for their survival. “The downside is [the ETN] is only as good as the bank’s ability to make good on that promise,” he says. “So, if the issuer of the bank standing behind the ETN goes under, then you can be wiped out entirely.”

An infamous example of this is Lehman Brothers, which launched its three Opta ETNs just months before its September 2008 collapse.

A bright future

Notwithstanding certain risks posed by ETPs, the class — particularly ETFs — continues to garner investor interest. The popularity of certain ETFs generally depends on two factors, according to Iachini. The first is the political, fiscal and economic climate of the domestic and global markets. Recently, for example, the continued low interest rate environment in the United States has led to a boom in fixed-income ETFs.

Iachini notes that emerging markets were another strong sector in 2012, and says that Europe is “starting to firm up” as investors regain some confidence in the future prospects of the Eurozone.

Second, money often flows into previously untapped asset classes that suddenly become accessible via new ETFs. “If they can get it in an ETF that they couldn’t get before, you’re likely to see some of those ETFs do well,” Iachini says.

On a broader scale, the popularity of ETFs is only likely to grow in the coming years, particularly if they become an investment of choice in 401(k) accounts, according to Pollackov, who notes that there are more than 7,000 U.S.-registered mutual funds compared with more than 1,400 ETFs.

“If I were a compare/contrast kind of person, I’d think we’d only be in the second or third inning of a nine-inning baseball game,” he says. “I think that only has room to grow.”